The Watney Rule for Startups — and the Return to the ‘Old Normal’

About a year ago, we published a quarterly letter to our limited partners — in which we talked about the risk that the “…industry as a whole will see a 3x decrease in returns…” and commented on some of the irrational behavior we were seeing in the market. Specifically, we focused on the changes to entry and exit prices — and how the sharp increase in entry prices over the last several years might impact returns for the venture asset class.

Recently there’s been a marked change in market sentiment — which has begun to impact startup valuations at every stage. Investors are beginning to realize that picking the right entry price makes the difference between picking a great company and generating great investment returns. And the market is waking up to the fact that many investors may have invested in great companies at inflated prices.

Given the publicconversationthat’soccurringabout the health of the market right now, we thought it would be helpful to publish our latest letter to our limited partners — and we do so here, completely unedited. While we don’t anticipate making most future LP communications public, we did want to continue to participate in this important discussion.

February 25, 2016

Dear Limited Partner,

We recently attended a board meeting of a First Round company that is experiencing strong growth (while burning a lot of cash). During the meeting, there was a conversation about the rapidly changing funding landscape. And one of the company’s (bullish) later stage investors warned the founder that the company should no longer rely on raising additional follow-on financing, saying, “We need to act like we’re Mark Watney in the Martian. We can’t assume we will get a shipment of new potatoes to save us.”

The Watney Rule For Startups

With a hat tip to Mitch Kapor, it’s clear that The Watney Rule for startups is rapidly becoming a new reality in the boardroom. Founders are realizing the need to rethink prior assumptions about prioritizing growth above all else, and are increasingly focusing on burn rate, profitability and the path toward self-sufficiency.

Just ten months ago, in our quarterly LP letter we talked about the risk that the “…industry as a whole will see a 3x decrease in returns…” and commented on some of the irrational behavior we were seeing in the market, saying that we “worry that many investors (both VCs and LPs) are still sitting down at the metaphorical blackjack table — and they actually haven’t figured out (or been told) that the math has changed. And that’s a recipe for a bad night at the casino.” We even took the unprecedented step of publishing that letter — to share our concerns with the broader industry.

While we are not about to join the experts who have been trying to call top on the market since 2004, it is clear that many VCs (and LPs) have begun to rethink their math in the attempt to avoid that “bad night at the casino.” There has been a marked shift in the capital markets surrounding technology startups. According to the Wall Street Journal, “Investors funded fewer U.S. startups in the fourth quarter than any period in more than four years. Since November, at least a dozen tech companies, which combined raised well over $2 billion in venture funding, have announced layoffs, letting go hundreds of people that in most cases represented at least 15% of their staffs.”

In the third quarter of 2015, there were 72 $100 million equity funding rounds for VC-backed companies. In Q4, there were only 39 of those gigantic growth equity rounds.

There were only nine new unicorns birthed in the fourth quarter, versus 23 in Q3.

Deal-making activity in general fell to its lowest levels since the first quarter of 2013.

We also see the shift reflected in founder sentiment about the availability of capital. In our recent State of Startups survey, we found that 95% of Series Seed, 97% of Series A and a whopping 99% of later stage founders feel that fundraising will get harder in 2016. And while 63% of founders surveyed felt that entrepreneurs had previously held the power in deal negotiations, only 46% felt that would still be the case over the next few years.

The Bet That Founders Made

The data shows a change in the market and calls into question the implicit bet that many founders have made over the past few years. Founders (and their investors) have assumed that their ability to access follow-on funding will remain fairly consistent and that the sole metric that matters is growth.

Fundamentally, the venture model is simple. A startup raises venture capital to accelerate growth — with their VC’s investment subsidizing short-term losses so that the company can focus on value creation for the long term. Implicit in this model are two core assumptions:

1. That future investors care far more about growth than profits/burn

2. That if they grow fast, the company can rely on raising additional funding rounds — at a low cost of capital.

For the last several years, these assumptions have been a fairly safe bet. Many founders have been able to raise venture capital, increase their burn rates to fuel growth, and then raise future financings at a higher valuation as a result of that growth. Over the course of the fourth quarter, we have seen signs that the core assumptions driving the late-stage funding market are starting to shift. We’re seeing later-stage investors place far more focus on burn rate and profitability (or at least decreasing loss rates and a clear path to profitability) — and, as a result, it’s getting meaningfully harder (and more expensive) for many companies that have high-growth plans that entail big losses to access later-stage capital. We’ve seen several companies achieve ambitious growth plans, yet still find it challenging to raise follow-on capital due to concerns about high burn and the fundamental unit economics of the business.

Obviously, there are many exceptions here. Some companies have grown so large, so fast (like Airbnb and Uber) that their ability to raise additional capital has not been impacted to date. Enterprise and consumer companies have different characteristics when it comes to cash profiles and funding needs… But in general, we’re encouraging our later-stage companies to review their assumptions around their burn rates and their ability to access additional capital in the near-term. Many private companies are pursuing operating plans that are predicated on old assumptions — and we’ve encouraged them to review their plans under new market assumptions, and make changes where appropriate.

Some might believe these changes represent a temporary “blip” in the capital markets — and that valuations and funding will quickly bounce back. We do not.

The Public / Private Market Dislocation

For the last several years, there has been a massive dislocation between valuations of public companies and valuations of private companies. When Facebook went public and its stock dropped by 50%, Twitter’s value actually increased in the private markets. When the public stock price of marketplace lenders (like LendingClub and OnDeck Capital) dropped, it somehow (magically) had little effect on the valuations of private marketplace lenders. This was a new — and scary phenomenon. It was as if promising baseball players in the minor leagues were suddenly able to earn a higher salary than veteran all-star players in the major leagues. Perhaps this was partially driven by the limited supply of promising high growth companies — which created an auction-type dynamic in which Greater Fool Theory drove prices. Or perhaps it was due to the fact that public companies trade every day (on good news and bad news), whereas private companies control when they trade (so they were able to have far more control of their valuation by only trading on good news).

This temporary dislocation is rapidly being corrected. According to the WSJ, of the 48 venture-funded U.S. tech companies that went public since 2014, 35 now trade below their initial public offering prices. And as public tech SaaS companies experience multiple-compression, we are finally beginning to see impact valuation expectations for private companies. As Redpoint’s Tomasz Tunguz put it, “Fundraising is a train and the public markets are the locomotive. It can take a while for the public market’s impact to be felt in the private markets, but there’s no denying the locomotive has halved its speed by more in 24 months.” While we haven’t seen a meaningful drop in the number of seed stage companies raising capital (our Q4 was busier than our Q3, for example), we (and others) have seen a meaningful drop in founders’ valuation expectations — both at the seed stage and at the later-stage.

We believe that starting in 2016, private and public companies will (once-again) begin to be valued in an increasingly consistent fashion. This change can (and will) be painful for many private companies. Companies that need to raise additional capital will have to price-test in the capital markets — and many will raise at lower prices than they previously did. And we worry that many private companies may unfortunately find that there is no market-clearing price at which they can obtain additional investment.

While some founders are responding aggressively to the market changes, many are not. Entrepreneurs, by nature, are optimists — it’s why they are successful. But unchecked optimism can be a founder’s Achilles heel. There is an entire generation of founders (and funders) who have only experienced one kind of market — the boomtime market of the last eight years. They have never experienced a downturn, and many believe that this is just a temporary blip. Some even believe that the venture capitalists who are blogging and tweeting about the market downturn are doing so in a deliberate attempt to drive valuations down (disregarding, of course, the impact that lower prices will have on that VC’s existing portfolio). We have been working aggressively to help coach our founders on the realities (and consequences) of market cycles. Indeed, at our CEO Summit last October we featured a talk on the ‘lessons learned’ by a founder whose company “hit the wall” in the 2000 dot com crash.

A key difference between today and prior tech market corrections is the fact that today’s valuation adjustments often happen in public — whereas before 2010, most private companies valuations were kept private. Indeed, before Facebook, it was extremely rare for a private company to publish their valuation. In the past few years, however, we’ve seen many private companies announce their valuation as a badge of distinction to help attract customers, press and employees. The fact that these private-company valuations are now shared with the public — combined with mutual-fund investors like Fidelity and T Rowe publishing monthly valuations on these companies — means that any valuation correction will happen in the glaring spotlight of the entire industry, exacerbating the negative impact.

A Return to the ‘Old Normal’

We clearly don’t believe that we at First Round are the only people who have noticed these changes. There has been a marked increase in the number of venture capitalists writing insightful blog posts talking about the changes in the market — and warning of a “new normal”. Yet, while we agree with their observations on the market changes — we don’t believe this is the “new” normal. Rather, we think (and hope that) this is a return to the “old normal.” A recognition that the >3x increase in valuations (and the metrics they were based on) over the last few years had gotten ahead of reality.

As a result, investors will change their lens from focusing solely on revenues and growth to also look at unit economics and burn rate. Founders will begin to make changes in core operating principles and resource allocation that might impact the lives of hundreds or even thousands of dedicated employees, vendors and customers. And ultimately, stronger companies will result. Don’t get me wrong, evolving from a unicorn into a cockroach will be extremely painful — but just like Mark Watney on Mars, the sooner you realize the situation on the ground has changed, the more time you have to “science the shit out of the problem” and succeed.

In each of our quarterly letters for the past several years, we have included a warning that “we are seeing companies raise follow-on financing rounds at much higher prices than we have seen before” and “we expect that several of our companies will end up being marked down over time (with many potentially being written off entirely).” We’ve modified this warning (somewhat) in this letter, as market volatility and uncertainty causes the industry to question later-stage valuations. Market prices have a tendency to swing too far at either end of a cycle. We continue to try our best to conservatively value our companies at a price that, we believe, represents their current fair market value — but recognize that this is difficult to do in a rapidly changing market.

Our Approach

While many in the market might be waking up to the new “math” of venture investing, we have been focused on this for quite some time. So we don’t expect to see any massive change to our investing strategy or pace in the coming quarters. We don’t anticipate sitting out the market. As we said in our Q1 2015 letter, “We believe that great companies emerge during both boom times and bust times — and that sticking to our investment model (and strategy) is especially important during both ends of the cycle… Great companies can be started in any market, and we have tried to remain disciplined (in an undisciplined market) and focused on the two numbers that matter: entry price and exit price.”

We continue to deploy capital in new investments, especially as market valuations begin to approach “old-normal” prices. Given our expectation that follow-on financing will be harder to raise, we are paying close attention to the runway and milestones of our new investments — along with the quality of co-investors in our syndicates to ensure adequate capitalization. For follow-on investments, we are tactically shifting to a more defensive posture — being a little more cautious in seeking out opportunities to buy up in companies so we can ensure adequate reserves to protect our core positions should the market continue to deteriorate.

Fund Performance

Attached you will find our fund Scorecards containing Gross and Net fund performance, as well as a summary of the publicly reported quarterly activity in each fund. While we are happy with (most of) our funds’ performances, we want to stress that most of the valuation increases are “unrealized,” and until these companies end up in the “realized” column (through IPO, M&A or secondary sales) the valuations are just paper increases. Our valuation policy requires us to value our portfolio companies based on market prices — and in today’s market we are seeing increased market volatility, resulting in increased uncertainty about appropriate valuations for later-stage companies. Past experience has shown that valuations can change significantly over time — and despite our best efforts, we expect that several of our portfolio companies will continue to be marked down over time (with many potentially being written off entirely).

Warm Regards,

The First Round Partners

Here’s the original version of the letter. Feel free to share or embed: